Sunday Supplement 210822 – The hammer and the dance – why the government must act now…

Aug 21, 2022



The Hammer; First, you act quickly and aggressively. The Dance; If you hammer the coronavirus(inflation), within a few weeks you’ve controlled it and you’re in much better shape to address it. Now comes the longer-term effort to keep this (economic) virus contained until there’s a vaccine (genuine economic recovery). – Tomas Pueyo – Coronavirus, The Hammer and The Dance (bold emphasis my own words).


In case you missed it, today’s quote is chopped and changed from a famous article shared in March 2020 by the overnight coronavirus expert and sensational brain, Tomas Pueyo. My (somewhat laboured) point is that inflation could be considered equally deadly compared to the coronavirus, if left unchecked. It could easily kill more people. It might have escaped from a lab, mutated from a bat, or been unleashed as a deliberate economic weapon. Economic ruin can kill more people than any pandemic, and some countries in the world are at risk, right now.


As often, we sleepwalk towards some of these outcomes. I’ve spoken, perhaps not enough, about my consideration that this is one of the great wealth creation opportunities of modern times. Property has been good to those of us holding a decent amount of it, in almost any country in the world, in the past couple of years. Let’s perhaps just revise HOW good in the UK with some select figures, all from the ONS/actual transaction based:


The past full decade versus the past 2.5 years – the facts

Decade of 2010s (10 years, to state the obvious): United Kingdom +38.4%; London +71.3%; West Midlands +35.4%; Yorkshire and the Humber +24.8%; Wales +30.3%; Scotland +16.7%; inflation +24.4% (all figures ONS HPI)


Jan 2020 – June 2022 (2.5 years): United Kingdom +23.5%; London +13.0%; West Midlands +22.4%; Yorkshire and the Humber +24.0%; Wales +30.6%; Scotland +25.2%; inflation +13.2%  


Roughly – 2/3rds of the past decade replicated in ¼ of the time, UK-wide. London – disappointing compared to last decade but not actually that far off the pace (compounded, that would be 63% for the decade). Midlands well above. Yorkshire, Wales have grown at 4 times the rate of the past decade. Scotland has been more like 6 times the speed. Inflation, of course, well on track to smash what it did last decade too (current 2.5 year rate compounded would be 64% inflation this decade).


How can inflation help, and how can it hurt?

Spectacular after a comparatively disappointing decade, London aside. Real returns preserved, after inflation. Look a bit deeper however – the power can be addressed with a worked example.


Let’s say you had a theoretical 2.5 year fixed rate mortgage, that went on a property purchase from Jan 2020. 


House bought at 100k which was fair value, grows at UK average of 23.5% – now worth 123500.


You paid 105k including all frictional costs. You borrowed 75k and put in 30k of your own money as a deposit/seed capital.


Position at end June 2022. Equity from 30k put in now up to 48.5k (61.6% return). Cashflow banked – one would hope – say £100 pcm only. £3000 in net rent banked. An extra 10% return on capital employed there too over the period.


Pretty nice given no value was added whatsoever. 

Option now to refinance, leaving still £100 cashflow pcm, at 75% of the new value – 17625 before arrangement fees etc to be released, say 15k after all fees. With 3k net rent collected, 18k of the 30k has been returned, within 2.5 years – 12k remains and equity of c. 30k for that 12k. 10 years payback if you never refinance again, and mortgage rate stays the same for 10 years. (1200 p.a., 12k left to pay). At the end, likely to be >50k capital growth overall. A phenomenal annualised return in the circumstances.


Not bad in just 2.5 years, for no particular alpha or skill at all – simply going through the motions.


Say you’d done nothing instead – your 30k now can only buy a house that in Jan 2020 was worth c.81k. You’ve had no cashflow to speak of. 


Multiply this exercise time and again, potentially, before this current peak of inflation is out. 


The difference is absolutely stark.


A lot of my logic here is predicated on the fact that this inflation wave, as I’ve been writing about for 18 months now, is going to hang around for longer than expected. It’s going to be more persistent than expected. We are already past the point where that can be deemed to be correct, and you know this because we have stopped hearing the word “transitory” in the press/media at all. We are already past what anyone could deem to be transitory.


What chapter are we at in the inflation story?

Instead, we are still a) seeing inflation rise and b) seeing inflation overshoot expectations, in the UK. In the US, we may be over the peak, but that’s subject to energy and commodity prices, the former of which has a major dependency on the Russia situation but other nuances including just how much oil the world can actually produce these days (especially without Russia), and the latter of which looks like it has had its major covid problems, but has plenty of other variables including just how much of certain commodities like Lithium are likely to be demanded over the next several years and decades.


Time to smash some myths

The above is also a great reason why not to get married to one particular metric, especially yield. I’ve been derided over the past 7-8 years since I’ve been significantly active on social media platforms for suggesting that cheaper housing in locations that tend to be more central or towards the north of the UK could exceed the capital growth on more expensive stock in the south-east of the UK.


I’ve never really understood why there is this supposed rule as to why that would be the case. The rule I can completely understand is expecting greater capital growth (in a percentage fashion) in the same area on more expensive stock. This, in my view, is much more to do with increasing fortunes for the top decile, or top 25%, of the population than it is to do with some mysterious “law” as to why this needs to be the case. It sounds like it makes sense. If I looked at the evidence of that in one particular area from above (the West Midlands region):


Since Jan 2015 – Flats +39.0%. Terraces +57.2%. Semis +58.8%. Detached +55.6%.


(for comparison, in the same time frame rents are up 16.6% according to the ONS, not split by property type unfortunately).


So – no evidence at all that more expensive houses go up more in value. Nothing statistically significant – but if you considered that the average rental yield on these types of properties during this time would likely be (no data available, my own opinion):


Flats: 6.5-7.5%; terraces 6-7%; semis 5-6%; detached 3-4%.(It is clear from the numbers that with 50%+ capital growth and only 16.6% rental growth, yields have deteriorated during the period in question). 


It’s very easy to see the best way to have acted, in hindsight.


The same exercise for London: 


Since Jan 2015 – Flats +23.5%. Terraces +44.4%. Semis +47.1%. Detached +45.3%. Interesting how the shape is almost exactly the same, but at a lower level.


Rents are up 10.1% in the same timeframe, so even more stark a yield decay in comparison to a lower performance in capital growth as well.

On top of that, more damagingly in my view, I would pitch the rental yields at the following levels:


Flats 5-6%; terraces 4.5-5%; semis 3.5-4.5%, detached 2.5-3.5% (with similarly deteriorating yields).




One more nuance to remember here though is that if the mortgage rate is 4%, the difference between a 5% and a 6% yield could be the difference between profit and loss in cashflow terms, and 7% is vastly superior to 5%, not just 2% better in cashflow terms.


For me, London underperforming was an easy call to make. There had been unsustainable growth in the first 5 years of the decade. Consider the average aggregate figures at the beginning of this article – London dragged up the national average and did nearly double the performance of the whole country over the decade. This was very much front-loaded. At the time many investors struggled to see why this was unsustainable, despite seeing first-hand areas like Islington increasing over 20% per year in certain years. I struggled to see why they struggled; there was a huge influx of cash from overseas, which was not controlled or controllable by the Bank of England or the Treasury – a limited leverage requirement – and a different motivation to these purchasers largely speaking. They were attracted by an international city and a stable rule of law, and a safe economic haven after a very rocky economic period. Instead of property abroad in the gulf – for example – that had been growing at 20-30% per year and then lost 70% or more in some cases in 2008-9 – they preferred safety to boom and bust assets.


Cycles, of course, continue and there is limited point looking back – the better way is to look forwards. Don’t be hung up on myths – always validate them. You could look back at regional data further back (it isn’t of particular quality before about 2005, unfortunately) and see similar patterns over the years. 


Great – well done – that’s what happened? So what? What next?

By using local and regional data – on infrastructure investment, business improvements, and these days freeports and other government investment schemes, the next growth areas are possible to predict. My easiest example “in anger” would be South Wales – it was depressed after the Brexit vote, at a high level simply because Wales received a disproportionate amount of EU funding. My view was that this seemed erroneous – there was not major evidence that this spending had had a particularly significant impact on the per capita incomes in Wales over and above any other part of the UK. There was also the fact that years in advance it was announced that the toll would be removed from the Severn bridge, and toll roads have a strange and disproportionate impacts on drivers in the UK, who are not conditioned to the road pricing model (compared to, say, France, where toll roads are commonplace – or the USA). There was, on top of this, a super-performance in the Bristol market which was not bubble-driven or happening due to particular external factors – the population in Bristol at one point was simply growing at 4% per year, which compared to a nationwide figure a little above 0.5%, was incredibly disproportionate – and with that many workers entering an area, rental boom was inevitable.


Putting this together, I built a portfolio in South Wales over the years 2016-2019 (mostly) and my only regrets are a) not buying more (of course) and b) not buying more even nearer to Bristol. However I found going west towards Swansea far easier to get deals than in Cardiff (no surprise) and the Newport market which I entered to start with, sadly quickly overheated.


Now, I am disposing of 20-30% of those properties, and may well sell more. Why? Wales has outperformed the whole of the UK as per the above figures in the past 2.5 years. I see limited reason to be long-term bullish on the specific location over and above the rest of the UK. A move away from the UK (not yet receiving major headlines, but with the Scottish direction of travel this looks inevitable, and the longer-term trend in the world at this time is nationalism and breakup) will create no economic value and is likely to destroy it (in the same vein as Brexit). More than anything though, the pattern has played out, and yesterday’s overperformers are more likely than not tomorrow’s underperformers. Capital growth built up in properties that, in the current market, are still over-selling in my view, is best cashed in on in spite of tax implications, and reinvesting. (I am also biased by a model that makes a good slice of capital uplift on the way into a deal, as I am buying “well” generally). 


Would I not buy in South Wales then? Yes, I would. My existing network and lead generation in the area means that a deal is still a deal. Am I putting as much time, effort and resource into it as I was in 2016-19? Absolutely not. 


So what of inflation?

Where does inflation fit into all of this? Well, of course a lot of the above is about the truly relevant inflation metric to regular readers of this article – house price inflation. This is largely unchecked and, indeed, specifically encouraged at certain points in the political cycle. There is also that inevitability about the long-term supply issue which is oft talked about, never fixed, and frankly unfixable given the constraints of the planning system, the skills shortages, and the all-points failure of the government since the 1960s (social, private, rental, etc.).


Why the reference at the beginning of this article? Well, the hammer in this instance is the central bank. Rightly or wrongly, they are being talked into the hammer, bit by bit. The Americans have unashamedly used the hammer in raising the funds rate by 0.75% 2 meetings in a row, and there is consideration of the same again at their next meeting next month. We British have been more, well, British about it, although we have accelerated to 0.5% hikes and the inflation print at 10.1% last week for July looks to make it more likely to go another 0.5% in September. These may not sound like large numbers – but in central banking this is the equivalent of the hammer.


I wrote last week of my feeling that perhaps the economic downturn would NOT be as stark as expected – part of this is predicated on a strong feeling that the new PM will not be foolish enough not to take significant action against the expected energy price cap rise on October 1st. Part is also predicated on a stronger and more resilient labour market than expected thus far. This week’s image is a graphical representation of just how tight the labour market currently is – the frame of reference over the last 20 years is interesting, as always a picture tells a great story.


The Hammer and the Dance

So the hammer – granted, a few taps rather than one, is underway. What of the dance? Well, that refers to potentially putting interest rates back down relatively quickly – but that will only happen in the event of a deep recession. If the economy is resilient enough to avoid this deep recession, then that is an unlikely scenario. What is equally likely and potentially a lot more damaging to property investors is an upside risk to the base rate rising above the highest current economic expectations (which are around 3.5%, the market is saying and most of the economic analysts are in the same ball park plus or minus 0.25%). I’m interested more in the tail risks and extreme scenarios, above 4%, to 7% (as Sunak has, and of course there is gamesmanship there, predicted), or to 10% as some have said. Double digits would absolutely crush the economy and lead to huge debt writedowns, which, frankly, wouldn’t be allowed to happen. So I see that as a one in 10,000+ probability. 4% and above, however, is definitely a live runner with a 15-20% probability in my book, perhaps as high as 25%. This is not my view of a terminal funds rate, but if it is what is “needed” to “control inflation” (read – destroy demand) then it is definitely on the table in this cycle.


In all markets, and central banks are particularly uncomfortable in moving quickly, there is a tendency to overreact. So, the funds rate is likely to overshoot before coming back down, and that will be the dance. For some reason, the dance is still being framed around a 2% government-inspired inflation target. I first wrote 18 months ago about considering the movement of the inflation target, which would have limited consequence if it were 3% rather than 2%, or even 4%. For a government indebted in a significant way compared to historical data, this would be self-interested, of course. The 2% is sensible because it is far enough above deflation, which is the truly damaging phenomenon – 4% has people scared because above 4% (and certainly above 5%) leads to danger, overheating, and runaway inflation. As yet this hasn’t been given any serious airtime – and with the Truss school of economics looking devoid of talent thus far, I don’t expect it to be (until it is too late). 


Does 4% base risk much in the housing market? On paper, it shouldn’t. The major market (residential mortgages) have been stress tested for a decade or so at a 5.5% pay rate. 4% base would see mortgages in personal names, on principal private residences, at around 5-5.5% in my view (margins would shift because savings would be getting say 2% or so). This does not create a deficit. However, creeping above 4 would definitely start to have an impact in the housing market.


It has long been observed that affordability is not the particular issue in terms of income per month when it comes to buying houses and having a functional, moving forward, property market. The issue is the deposit, and the issue gets bigger as capital growth continues. However, the issue gets easier when wage growth outpaces house price growth (this is the overwhelming likelihood over the next 12 months, although there is an awful lot of catching up to do after the past 2.5 years, of course).


So here is the dance. And, like the coronavirus pandemic, the variable (inflation) is out of control. Arguably, it has already mutated this time around, and is not yet at the more benign Omicron variant! So what is the vaccine?


The vaccine is genuine, underlying, economic growth. I’ve written several times over the past years of the phenomenon I call “fakeflation”. Inflation not coming from an overheating economy, wage demand driven – but from other phenomena. First, the brexit referendum – 3 and a half years before anything really happened on that front, a massive shift in the value of the currency – as net importers, it put inflation up from lacklustre and nearly nothing to 4% or so. Controllable at the time and perhaps no bad thing, particularly for property investors.


The pandemic, supply, net zero and the end of oil

Now – the pandemic inspired inflation. One big variable is just how big some of these latent problems are, and how long they will hang around for. Supply is not sorted. China has had a disappointing Q2 economically and when they recover and finally knock zero covid on the head (could be a year yet) this is a shot in the arm for the global economy. China exports a lot and that’s how we normally think of them of course, but they import a lot too, when it comes to commodities especially (in order to turn them into finished products, of course). This suppression of Chinese domestic demand filters through to lower commodity pricing – great, and needed, right now, but we know that time passes and that will change, providing another inevitable surge in commodity pricing when that does happen. 


The supply shortgages and considerations created by the pandemic, or, more accurately, highlighted by the pandemic, are a concern. The reality is that the world is still growing in population, and using more energy every year. ESG policies are starving fossil fuel development infrastructure – the quest for net zero is completely laudable and necessary, but the methodology at this point of actually getting there is badly flawed, and if badly managed, could easily kill more people than global warming itself. Many, in my view incorrectly, believe that oil will just filter out quietly – I see it at $500+ a barrel before 2050, as supply and demand imbalance is poorly managed. If you want to see inflation – just imagine what that would do to pricing of fuel, food and the likes – and the global oil supply comes mostly from suboptimal countries from a Western hegemonic perspective, to say the least. And it isn’t a fast problem to fix.


So that’s more likely to be the inflationary dance. The key, though, is to stay calm and trade through it. Remember my favoured ratio from some months back:


Floating rate debt:Fixed rate debt:Cash at Bank


In stable and safe times, with ultra low rates, it has been fine to be at 45:45:10 or, if particularly aggressive or with pledges to support in times of cashflow problems, even 48:48:4 or lower. I’ve not tracked this metric over the years, but there would be times when I would have been at 2% or lower on the right hand side. Not for the faint hearted, and definitely risky – but in times where there has been very limited economic macro risk. 


This isn’t the time to be operating on anything less than 10% Cash at Bank, and frankly, floating rate debt looks a poor short term option right now. I’m currently above 10% on the right hand side looking to get to 15%, and under 15% on the left hand side and going downwards by moving onto fixed rates, to weather any potential interest rate upside storm well. 5 year fixes are cheaper and kick the can far enough down the road to be able to make the most of the opportunities that are inevitable over the next few years, recession or not.


Financial structure sorted – what now?

Can’t refinance? You can always consider sale. That’s also one of the driving factors in my strategy this year, and what a fabulous market it has been to sell in. Admittedly I am selling to increase Cash at Bank and/or reinvest, but again, a model that buys well with a great financial structure and lender support provisions for the sale of one property to provide seed capital for 4, or 6, or 10 more. 


Planning purchases? Expect rates at or around 4.75-5% when you come to refinance in 6-9 months time. That’s the correct provision, in my view, right now. This means a lot doesn’t stack, and indeed, in my model, is pushing me towards higher cash flowing assets – shops and tops, which often have development opportunity – even at 6% mortgage rates, have a lot more juice at 10-12-15% gross yield than a resi property with a 6% yield, which might net to 4.5%, before a 4.75-5% mortgage meaning you are risking gearing down, rather than gearing up, which can be just as damaging as deflation, particularly if capital growth does stall for a couple of years, which is possible from here.


Sitting on the sidelines, waiting for the crash? Had to include it for completeness. Once again – no, no, no, no, no. If and when it does come, you will be irrelevant, starting a pipeline from scratch. Distractions will creep in. Discipline will slip. Relationships will be freezing cold. There’s deals in any market – they just look different. I am finding solace in cash flow and recession-proof or recession-hardy commercial assets, alongside high-yielding residential. This may be no surprise – my one true consistency has been chasing yield, but I maintain that 90%+ of businesses go out of business because of cashflow problems rather than fundamental issues, so it makes sense to me to build cashflow.

Until next time – as always, shares very much appreciated, comments always very welcome – keep calm and carry on…….


Postscript – why can interest rates keep going up – because employment is strong…..although numbers are still a bit false due to 300,000+ further people out of the workforce on long term sick, mostly citing long covid. Graph: